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Index Fund Investing: Is It Right for Me?

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Low-cost, low-risk, simple and effective — index funds check most of the boxes people want in their investment tools. They’re also widely hailed by experts as an average investor’s best bet to reach their long-term investment goals. But what exactly is an index fund, and more importantly, is it right for your portfolio?

What is an index?

At the most basic level, an index is a measurement of how well a related group of stocks or other assets are performing — a thermometer of sorts. Before we dive too far into index funds, it’s first important to understand what an index is.

Indices may include just a handful of stocks or other assets, or they may include hundreds or thousands of them. The performance of the companies or commodities within each index are factored together to gauge the performance of the overall group.

There are thousands of market indices. Some of the largest stock indices include:

  • Dow Jones Industrial Average (DJIA): This is one of the oldest indices, established back in 1896. The DJIA index includes 30 large-cap stocks, such as Microsoft, Disney, Walmart and more.
  • S&P 500: This index includes 500 mid-cap and large-cap companies, such as Apple, Microsoft, Boeing, Nordstrom, Starbucks and other industry leaders.
  • Russell 2000: This index is made up of 2,000 small-cap stocks.

Indices aren’t just for stocks, however. They exist for an array of different asset classes and segments of the economy. They serve as indicators of how a related group of assets — like large- or small-cap stocks, or a group of companies in the same industry — are performing. Some of the largest non-stock indices include the Chicago Board Options Exchange’s (CBOE) Volatility Index, the Consumer Price Index (CPI) and the Producer Price Index (PPI).

Market indices are established by financial firms and government regulators, but you can’t invest in indices directly. You can, however, invest in index funds.

What is an index fund?

Index funds are made up of stocks and bonds that replicate the makeup of an underlying index. The goal is always to match the performance of the underlying index as closely as possible.

Some index funds invest in all of the stocks or other assets that comprise the underlying index, while others are more selective and only invest in a portion of the assets that make up the index. For instance, the component stocks in an index may be weighted, meaning the performance of the entire index is impacted more heavily by the performance of a chosen subset of companies within the index.

What to know about index fund investing

For investors, investing in index funds means that instead of picking and choosing each individual stock to invest in, they’re investing in a predetermined group of stocks. This delivers that key component often thought to be so essential to successful investing — diversification. Your profits and losses are measured by how the collective group of companies within the fund does rather than just on how one stock performs. In other words, your proverbial eggs aren’t all in one basket.

Index funds are a passive form of investing. Since the investments are predetermined by the indices, not only do you not have to individually choose the stocks, actively follow them and make decisions about when to buy or sell them, but an advisor doesn’t have to either. Therefore, the fees you must pay to an advisor are typically lower.

Another bonus: Since index funds are meant to be held for long periods of time rather than to be bought and sold as the market fluctuates, investors often benefit from some tax advantages, such as avoiding short-term capital gains taxes. Less money spent on fees and taxes means more money to invest and accumulate interest.

Pros and cons of index funds

Pros

  • Simple to understand: You don’t have to be a financial expert to understand and invest in a mutual fund. They’re quite straightforward, and once you invest in one you can “set it and forget it,” knowing your money is working for you.
  • Offer diversification: Index funds pool investors’ money together in order to purchase shares. This allows people to invest in a broader array of companies than most average investors would likely be able to do if they tried to invest in each one within an index separately.
  • Low cost: Because index funds require little work on the behalf of a financial manager, the fee for them is typically less than those associated with actively managed mutual funds. There may also be tax benefits since they’re meant to be held long-term instead of being frequently bought and sold.
  • Lower risk than other investments: Because you’re investing in a group of companies rather than just one or a few, you take much less of a hit if one tanks. The swings of a group of companies are typically less volatile than those of individual companies.

Cons

  • Potentially lower returns: The biggest drawback to index funds for some is that they may not provide the huge payoffs compared with some actively managed accounts that try to beat the market. They do, however, traditionally perform well in the long term.
  • Not designed for frequent trading: If you’re someone who likes to buy and sell stocks frequently and participate in day trading, index funds may not be your best choice. They can only be purchased and sold once a day, and they’re better used as long-term investments.

How is an index fund different from a mutual fund?

An index fund is actually a type of mutual fund. Mutual funds are financial vehicles that pool investors’ money and invest it in groups of stocks, bonds and other assets within certain segments. For example, some mutual funds may invest in foreign stocks, while others invest in domestic stocks.

Passive management: What sets index funds apart from mutual funds is that they’re invested to match the performance of one of the market indices. While most mutual funds are actively managed by a professional fund manager who decides how to allocate the investments and when to buy and sell them, index funds are a subset of mutual funds that are passively rather than actively managed.

Less work — and lower fees: The work to set up and maintain your investments in an index fund is quite simple and doesn’t require the same amount of research and work that other mutual funds do. Once you invest, there’s no worry about following the markets and trying to gauge when to buy and sell. Index funds are meant for long-term growth, and you can simply “set and forget” them until you need the funds down the road. Therefore, the fees associated with them are typically much lower.

Likely lower returns: Will index funds see the same huge returns that some (rare) individual stock investments do? Probably not, but, in general, they’re less risky than actively managed accounts that try to beat the market. Typically, they perform better, too. According to the December 2019 S&P Indices vs. Active funds scorecard, over a five-year period, the S&P 500 index did better than 80.6% of actively managed stock funds.

Top index funds

Perhaps the most challenging part about index fund investing is picking the one(s) in which you want to invest. As we said, there are literally thousands of index funds from which to choose. A financial advisor can help you narrow down your choices, but in general, you want to look at the following three factors when choosing an index fund:

  • Makeup of the index: Which type of companies and commodities is the index following? Do you want to invest in a certain sector or in a more diverse range? Look at your existing portfolio and see how you might be able to add some diversity.
  • Minimum investment: This is the amount you need to have upfront to start investing in a particular fund. While the amount varies by fund, the minimum investment typically falls between $500-$3,000.
  • Expense ratio: You’re not presented with a bill for the fees associated with your index fund — rather, they’re deducted from your fund in the form of an expense ratio. The ratio is a fixed annual percentage of your assets. So if you have $1,000 invested in a fund with a 0.05% expense ratio, 50 cents per year will be deducted from your fund. You can find many index funds with expense ratios of .05% or less. You may want to think twice about any that exceed .10%.

Here are some of the top index funds you may want to consider:

Vanguard S&P 500 Index fund

The Vanguard S&P 500 Index fund is the oldest index fund for individual investors. It includes 500 of the largest companies in the United States in various industries (those in the S&P 500). The Admiral Shares fund requires a minimum $3,000 investment and has an expense ratio of 0.04%.

Schwab S&P 500 Index Fund

The Schwab S&P 500 Index Fund was founded in 1997. As its name implies, it also follows the S&P 500. There is no minimum deposit required, and the expense ratio is 0.02%.

iShares Barclays Capital U.S. Aggregate Bond Index Fund

The Barclays Capital U.S. Aggregate Bond Index follows bonds, and there are a variety of funds that follow it, including the iShares U.S. Aggregate Bond Index Fund, which is one of the most prominent. Its expense ratio is 0.04%, and the minimum investment is $1,000 with a few exceptions.

Invesco DB Commodity Index Tracking Fund

The Invesco DB Commodity Index Tracking Fund invests in the commodities included in the DBIQ Optimum Yield Diversified Commodity Index Excess Return. The index is made up of 14 heavily traded commodities, including heating oil, gold, silver, corn, wheat and sugar. The expense ratio is 0.89%, and while there is no minimum investment listed, they do warn that there may be substantial risk investing in it as futures contracts are volatile.

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ETF vs Mutual Fund: Which Is Right for Me?

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Mutual funds and exchange-traded funds (ETF) are investment vehicles that make it easy to put your money into a mix of assets, providing investors with varying degrees of diversification. However, there are key differences between ETFs and mutual funds when it comes to how they are managed and how much they cost to invest in.

To determine which is better for your portfolio, here’s what you need to know about mutual funds versus ETFs.

What is a mutual fund?

A mutual fund is an investing vehicle that buys a highly diversified portfolio of assets — stocks, bonds and other securities — and sells shares in the fund to outside investors. Typically, financial professionals actively manage the mutual fund’s portfolio, watching the ebbs and flows of markets and undertaking in-depth research in a concerted effort to beat the market.

According to the most recent statistics from the Investment Company Institute, 92% of those who invest in mutual funds are doing so to save for retirement. Most of them invest in mutual funds via an employer-sponsored retirement plan. Beyond retirement, people also use mutual funds to save for emergencies and/or educational costs.

You may buy shares in a mutual fund directly from the firm that manages the fund or from a broker. Mutual fund shares can be bought and sold daily, though you can only do so once a day based on the net asset value (NAV), which is determined only once a day at the market’s close and is calculated by the fund’s value per share minus its liabilities.

Because they’re actively managed, mutual funds typically charge customers a variety of fees, which may include an expense ratio, distribution fees, fees for purchasing and selling and other fees. Most mutual funds also require a minimum investment, which is typically $500-$1,000 or more.

Passively managed mutual funds

While mutual funds are typically actively managed, there is a subset of mutual funds called index funds that are passively managed. Index funds buy a portfolio of assets in an attempt to mimic the performance of various indices, such as the Dow Jones Industrial Average or the S&P 500.

Because their makeup is largely predetermined and they’re made to “set and forget” rather than to be traded frequently, they are considered a passive investment. That means they typically don’t come with nearly as many fees as most mutual funds.

What is an exchange-traded fund (ETF)?

Like mutual funds, ETFs pool funds from outside investors and buy a portfolio of assets. Unlike mutual funds, however, ETF shares can be purchased and sold throughout the day, just like individual stocks, with the prices fluctuating along with the market.

Most ETFs are passively managed, meaning there’s no financial professional picking which assets to invest in and when to trade them. Instead, most ETFs mimic financial indices. ETFs typically come with fewer fees than mutual funds because they don’t require as much work on behalf of a professional manager.

Anyone can buy ETF shares, and you can buy as little as one share at a time. ETFs are only sold as full shares, however, so if you automatically invest a set amount of money on a regular basis, there may be funds leftover that sit uninvested until you have enough for another full share.

ETFs vs mutual funds: Similarities and differences

While there are various types of mutual funds and ETFs, in general, both investment vehicles provide a way to diversify a portfolio. These investment vehicles usually differ in how they are purchased, the minimum investment, and their overall cost.

Purchase

ETFs are sold by the share and can be purchased throughout the entire trading day, with fluctuating prices just like stocks. Mutual funds, on the other hand, must be purchased directly from the fund and typically require a minimum investment. While you can place an order to buy or sell mutual funds any time during the day, transactions are only made once a day at the close of the market, and the price is calculated based on the NAV.

Investment minimums

The minimum required investment varies, but most mutual funds allow investors to purchase partial shares, which is beneficial if you automatically invest a set amount of money, such a through a 401(k) plan. In contrast, ETFs can only be purchased by the share. That means if you automatically invest $50 each month, but the ETF shares are $40, then $10 would go uninvested until your next transaction when you can fund the full price of a share.

Risk

Both ETFs and mutual funds pool investors’ money to buy an array of stocks, bonds or other assets. They provide diversification, which minimizes risk if individual companies should tank. Neither mutual funds nor ETFs offer any guarantees, however, and they’re not insured by the government, so there’s always potential risk that you could lose money.

Management

Most mutual funds are actively managed, with the exception of index funds. ETFs are usually passively managed, and buying and selling are often managed via a computer algorithm.

Cost

In general, mutual funds charge investors more fees because they require more work from an account manager or team of managers. ETFs are passively managed and require less work, so they tend to be less expensive, though there may still be fees associated with them. With both mutual funds and ETFs, the fees you must pay take away from the total amount you’re able to invest.

Tax efficiency

ETFs also typically come out ahead when it comes to taxes. When mutual fund shares are sold throughout the year at profit, shareholders are granted those gains, which means they’re then subjected to capital gains taxes. ETF transactions, on the other hand, are typically classified as exchanges and generally avoid capital gains taxes.

Note that if either your mutual fund or your ETF is within a retirement plan like a 401(k), you don’t have to worry about the taxes until you withdraw funds from the account.

Should you invest in ETFs or mutual funds?

ETFs may be a better choice for investors who prefer more flexibility and lower fees, while mutual funds may be a better choice for those who want more choices, are looking to try to beat the market and want a fund manager to actively make decisions about their investments.

While both offer benefits in terms of ease of use and diversification, they also come with fees, expenses and taxes that can reduce the amount you’re able to invest and potentially grow with compound interest. Also note that individual mutual funds and ETFs often vary greatly in terms of fees, risk and other details, so it’s important that investors carefully compare all funds they’re considering before making any investments. Thorough comparison shopping is the best way to ensure you know exactly how your money is being invested and to garner the best returns.

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Everything You Need to Know about Spousal IRAs

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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A spousal IRA is an investment strategy used by married couples to save for retirement. There is no separate type of individual retirement account called a “spousal IRA” — rather, it’s just a traditional IRA for a married person who isn’t earning an income. IRS rules allow spouses who aren’t earning income, for whatever reason, to still use the tax advantages of saving and investing money in an IRA to accumulate a nest egg for retirement.

What is a spousal IRA?

The IRS requires individuals to report annual income in order to fund an IRA — with the exception of a spouse who isn’t earning an income, but is married to someone who is. If both partners in the marriage file taxes jointly, the IRS lets each partner have their own IRA. Married couples who file taxes separately are not eligible for the spousal IRAs approach.

According to Janice M. Cackowski, a financial advisor with providence Wealth Partners in Ohio, the IRS looks at married couples who file jointly as one entity, and their combined income as one figure, so spousal IRAs allow them to put away twice as much.

“Spousal IRAs are terrific tools when one spouse is employed and the other is not,” said Cackowski. “It allows the spouse who is earning wages to deposit them an IRA for the benefit of the non-working spouse, essentially allowing each spouse to maximize their retirement savings.”

Basic spousal IRA rules

  • The tax filing status of the couple must be “married filing jointly”
  • The married couple does not co-own a spousal IRA — it is owned by and held in the name of the non-working spouse
  • Spousal IRA can be a Traditional IRA or a Roth IRA
  • There is no longer an age limit for making contributions to a Traditional IRA, so you may keep adding money after age 70 ½, as has always been the case with a Roth IRA

Like any other IRA, married people making use of a spousal IRA strategy contribute funds to their separate accounts and invest the funds in stocks, bonds, CDs and other assets. Interest accumulates over the years, and the account grows either tax-free or tax-deferred (more on this in a bit).

For example, if you contribute $6,000 a year to your IRA starting at age 30 until you retire at age 65, the sum would grow to more than $700,000, assuming a 6% annual rate of return. This figure doesn’t account for taxes (so it’s not entirely exact), but it does show how the power of compound interest can work in your favor over time.

What are your spousal IRAs options?

Your spousal IRA can be either a Traditional IRA or a Roth IRA. The rules and contribution limits for spousal IRAs are no different than conventional versions of either account. Remember, the difference between a Roth IRA and a Traditional IRA comes down to when you can reap the tax benefits of each option, and Traditional IRAs may provide tax deduction benefits.

  • Traditional IRA: Contributions to a Traditional IRA are made before you pay income tax. As such, you end up paying income taxes on all withdrawals — principal and interest earned — when you withdraw funds in retirement.
  • Roth IRA: Contributions to a Roth IRA are made after you pay income taxes. Since you’ve already paid taxes upfront, money you withdraw in retirement is tax free.

Which should you choose? In general, if you’re in a lower tax bracket now than you expect to be when you retire, then a spousal Roth IRA may be more beneficial, as you may save money on taxes down the road. This decision is unique in each situation.

Spousal IRA contribution and income limits

For 2020, the annual contribution limits for both Traditional IRAs and Roth IRAs is $6,000, or $7,000 if you’re 50 or older. This is the core benefit of a spousal IRA: A married couple can potentially sock away a total of $12,000 into their IRAs.

There is no income threshold for contributing to a traditional IRA, while the limit for contributing to Roth IRAs is $206,000 for married couples filing jointly. Also, In addition, for both Roth IRAs and Traditional IRAs, the married couple must have taxable income that is equal to or greater than the total amount contributed to their IRAs.

Spousal IRA tax deductions

Couples can deduct their contributions to a Traditional IRA from their taxes, depending on two factors. The income tax deduction is reduced or eliminated entirely depending on the couple’s total income, or the earning spouse’s participation in an employer-sponsored retirement plan.

If the spouse who works is covered by their employer’s retirement plan, the Traditional IRA income tax deduction is phased out when the couple’s income falls between $104,000 and $124,000. Incomes above $124,000 get no tax deduction.

However, if the spouse does not participate in an employer-sponsored retirement plan, the deduction phases out at an income level of $196,000, and is eliminated after income hits $206,000. There are also tax credits available — the Saver’s Credit — for married couples filing jointly who earn less than $65,000 a year.

Spousal IRA withdrawals

Because IRA funds are intended for use in retirement, withdrawing them before that time often comes with a penalty. For traditional IRAs, there’s a 10% penalty if you withdraw funds before age 59 ½, and you also must pay taxes on the money you withdraw. For Roth IRAs, you can withdraw the funds you contributed at any time penalty free, since you already paid taxes on them up front, but you’ll pay a 10% penalty on any earnings if you with withdraw them sooner than five years after the account was opened or before age 59 ½ (whichever is longer).

For both traditional and Roth IRAs, there are some exceptions to early withdrawal penalties for things including death, disabilities and a first-time home purchase.

Who should consider a spousal IRA?

Any family with a non-working spouse and disposal income for long-term savings that is looking to increase their retirement nest egg should consider a spousal IRA as a potential option.

According to Michelle Buonincontri, an Arizona-based certified financial planner and certified divorce financial analyst, spousal IRAs help protect the non-working spouse in the case their happily ever after doesn’t end quite so happily.

“Let’s face it, with 50% or more of first marriages ending in divorce, spousal IRAs are a great way to level the playing field by having retirement assets in the name of the spouse that does not have access to a retirement plan if a couple ever find themselves in a divorce situation,” she said.

Although retirement assets accumulated during the marriage are usually considered marital assets, Buonincontri suggested that “folks seem less emotional about letting the other spouse keep accounts titled in their own name and less tense during the marital settlement negotiation process.”

Spousal IRAs aren’t for all couples

This doesn’t mean contributing to a spousal IRA is right for every couple, however. While spousal IRAs are generally a positive investment, people need to take a hard look at their financial situation to make sure funds won’t be needed elsewhere.

Diane Pearson, a certified financial planner with Pearson Financial Planning in Pittsburgh, Penn., noted that a spousal IRA isn’t always the first move couples should make with disposable income.

She advised that couples should build their emergency fund and general savings before opting for a spousal IRA. Savers don’t want to set themselves up for additional taxes or early withdrawal tax penalties if they end up needing to pull funds out of an IRA to pay for near-term emergencies or a child’s education before age 59 1/2.

“Every situation is obviously different, but if an employer is offering the working spouse a match to a qualified retirement plan, and the individual instead decides to use their income to fund their non-working spouse’s IRA, they may be missing out on the employer’s matching contribution,” said Pearson.

How to open a spousal IRA

As we noted in the introduction, a spousal IRA is a strategy, not a distinct type of individual retirement account. Whether you choose to set up your spousal IRA as a Traditional IRA or a Roth IRA, you can do so through most banks, brokerage and wealth management firms, as well as robo-advisors.

For more help determining which might be best for your IRA needs, visit our list of the best IRA account providers, and the best robo-advisors.

How hands-on you want to be when it comes to managing your IRA will help you decide which route to go. While some providers will do all the work for you, you’ll pay for that help in the form of management fees, other brokers give you complete control over your portfolio and you save on fees.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.